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Options

Options. An option is a contract between two parties, let’s call them the writer and the owner . The key feature of an option is that the owner chooses whether the contract is exercised . Options.

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Options

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  1. Options An option is a contract between two parties, let’s call them the writer and the owner. The key feature of an option is that the owner chooses whether the contract is exercised.

  2. Options • Department Store gives customer the option to return merchandise for exchange or store credit. • Owner of a health insurance policy has the option to see a doctor. • Owner of a convertible bond has the option to convert it into stock.

  3. Options • The owner of a Call Option has the option to buy an underlying asset for a specified price. The writer has the obligation to sell if the option is exercised. • The owner of a Put option has the option to sell an underlying asset for a specified price. The writer has the obligation to buy if the option is exercised.

  4. Options Like a future, an exchange-traded option: • Has two parties, a buyer and a seller • Sets a price today for a transaction later Called the Exercise Price or Strike Price • Has an expiration date • Clearinghouse acts as intermediary

  5. Options Unlike a future, an option • Is exercised at the discretion of one party (owner). • Requires the buyer (owner) to pay a premium to the writer at the time the contract is initiated.

  6. Options European-style options can be exercised only on the day they expire. American-style options can be exercised any time prior to expiration.

  7. OptionsCall Options Example: April 55 Microsoft Call • Underlying Asset: 100 Shares Microsoft • Expiration Date: Third Friday in April • Strike Price: 55 American-Style The owner of this option can buy 100 shares of Microsoft for 55/share anytime prior to expiration.

  8. OptionsCall Options On December 28 • Microsoft was trading for about 45.25 • The premium for the April 55 call was about 3.25 per share. Find out where the market is today

  9. OptionsCall Options You buy 10 April 55 Microsoft calls Initial Investment = ($3.25/share) X (100 shares/contract) X (10 contracts) = $3,250

  10. OptionsCall Options On the third Friday of April: If MSFT = 54 You have the right to buy for 55 But you can buy on the market for 54 The options expire Out of the Money Do not exercise. Loss = $3,250

  11. OptionsCall Options If MSFT = 60 You have the right to buy for 55 The options expire In the Money Exercise: Buy 1,000 shares at 55 You can sell them at 60 Profit = (60-55)*1,000 – 3,250 = $1,750

  12. OptionsCall Options If MSFT = 56 You have the right to buy for 55 Exercise: Buy 1,000 shares at 55 You can sell them at 56 Exercise: Loss = 1,000-3,250 = -$2,250 If you do not exercise: Loss = -$3,250

  13. OptionsCall Options Payoff Function The payoff of a call option is equal to: max(0,S-K) S = Price of stock at the time the option expires K = Strike Price MSFT Example : Payoff = max(0,S-55)

  14. OptionsCall Options Payoff Table

  15. OptionsCall Options Payoff Diagram Payoff 55 S

  16. OptionsCall Options C = Initial Premium V = Payoff at Exercise or Expiration Profit per share = V-C Return = (V-C) / C MSFT=54 Profit = -3.25 Return = - 100% MSFT=56 Profit = -2.25 Return = - 69% MSFT=60 Profit = 1.75 Return= 54%

  17. OptionsCall Options Profit/Loss Diagram Profit 55 S -3.25

  18. OptionsCall Options Breakeven Point C = Initial Premium K = Strike S = Stock price when you exercise You break even if: S = K+C MSFT Example: Breakeven point: S = 55 + 3.25 = 58.25

  19. OptionsCall Options Buying a Deep out of the money option is like buying a lottery ticket. Example: On December 27, Lucent is at 13.125 The January 40 call is trading at .0625 Buy calls on 16,000 Shares for $1,000 Lose 100% almost certainly If Lucent goes to 45, Payoff = $80,000

  20. OptionsCall Options Buying a deep in the money call is like buying the stock on margin. Example: On December 28, GE is at 48.375 The January 20 call is trading at 28.50 A: Buy calls on 700 Shares for $19,950 B: Buy 700 shares at 59% Margin for $19,950 (Borrow $13,912)

  21. OptionsCall Options On the Third Friday of January If GE is at 55: A: (700) (55-20) = $24,500 B: (700) 55 – 13,912 = $24,588 - Interest If GE is at 40: A: (700) (40-20) = $14,000 B: (700) 40 – 13,912 = $14,088 - Interest

  22. OptionsCall Options Deep in the Money Call vs. Margin Buy • The option position has a small loss of value due to the option premium • The margined position has a small loss of value due to interest on the margin loan • The option position expires • Margined position subject to a margin call • Option position will do better in a crash

  23. OptionsPut Options Example: June 30 McDonalds Put • Underlying Asset: 100 Shares McDonalds • Expiration Date: Third Friday in June • Strike Price: 30 American Style The owner of this option can sell 100 shares of McDonalds for 30/share anytime prior to expiration.

  24. OptionsPut Options On December 28 • McDonalds was at about 34 • The premium for the June 30 put was about 1.25 per share. Find out where the market is today

  25. OptionsPut Options You buy 50 June 30 McDonalds Puts Initial investment: 50*100*1.25= $6,250 At expiration: If MCD = 32 You can sell for 30 if you exercise You can sell for 32 on the market Do not exercise.

  26. OptionsPut Options At expiration: If MCD = 28 You can buy for 28 on the market You can sell for 30 if you exercise Payoff = (30-28) * 5000 = $10,000 Profit = $10,000 - $6,250 = $3,750 If MCD = 29 Payoff = $5,000 Loss: -$1,250

  27. OptionsPut Options Payoff Function The payoff of a put option is equal to: max(0,K-S) S = Price of stock at the time the option expires K = Strike Price MCD Example : Payoff = max(0,30-S)

  28. OptionsPut Options Payoff Table

  29. OptionsPut Options Payoff Diagram Payoff 30 S

  30. OptionsPut Options Profit/Loss Diagram Profit 30 S -1.25

  31. OptionsPut Options Breakeven Point P = Initial Premium K = Strike S = Stock price when you exercise For a put, you break even if: S = K-P MCD Example: Breakeven point: S = 30 - 1.25 = 28.75

  32. OptionsPut Options Deep out of the money Put Example: On December 29, IBM is at 85 The January 45 put is trading at 0.125 Buy puts on 10,000 shares for $1,250 Lose 100% almost certainly. If IBM goes to 40, payoff = $50,000

  33. OptionsPut Options Deep in the money Put Example: On December 29, IBM is at 85 The January 160 put is trading at 75.25 A: Buy puts on 100 shares for $7,525 B: $7,525 in cash and short sell 100 shares

  34. OptionsPut Options On the Third Friday of January If IBM is at 95: A: (100) (160 - 95) = $6,500 B: (100) (85-95) + 7,525 = $6,525 + Int. If IBM is at 75: A: (100) (160 - 75) = $8,500 B: (100) (85-75) + 7,525 = $8,525 + Int.

  35. OptionsPut Options Deep in the Money Put vs. Short Sale • The option position has a small loss of value due to the option premium • The margined position has a small gain of value due to interest on the margin • The option position expires • Short position subject to squeeze • Option position better if stock skyrockets

  36. Markets Physical Delivery means that the short party on a futures contract (or the writer of an option) must deliver the underlying asset. Cash Settlement means that instead of the underlying asset, the short side delivers the cash equivalent of the current value of the underlying asset.

  37. CBOT Grain Futures Metals Futures Electricity Futures CME Livestock Futures Currency Futures CBOE Stock Options AMEX Stock Options PCX Stock Options PHLX Stock Options MarketsPhysical Delivery

  38. MarketsCash Settlement With cash settlement, the underlying need not be a traded asset. Stock IndexMortgage Index Interest RatesWeather Commodity IndexCatastrophe Index Muni Bond IndexCrop Yield Agricultural Index

  39. MarketsIndex Options CBOE Index Options AMEX Index Options PHLX Sectors Index Options

  40. CBOT CME NYMEX NYBOT KCBT MIDAM MGE CBOE AMEX PHLX PSX ISE MarketsDerivatives Exchanges – United States

  41. EUREX LIFFE MATIF MEFF OM BSX AEX CDE SAFEX SFE TIFFE OSE HKFE KLOFFE COMMEX BMF MarketsInternational Derivatives Exchanges • IPE • LME • TGE • TOCOM • WCE • MONEP • SHFE • BC

  42. MarketsOver The Counter (OTC) OTC Derivatives are negotiated directly between the two parties Global Market • Swaps • Forwards • Options • Caps/Floors • Swaptions • Exotics • Interest Rates • Currencies • Equities • Commodities • Credit

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